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Dollarization D000181 dollarization This article focuses on dollarization, a situation in which a foreign currency (often the US dollar) replaces a country’s currency in performing one or more of the basic functions of money. The distinction between official dol- larization and endogenous dollarization is discussed, as are the concepts of currency substitution and liability dollarization. Implications for monetary and exchange rate policy are emphasized. Dollarization is a situation in which a foreign currency (often the US dollar) replaces a country’s currency in performing one or more of the basic func- tions of money. Thus in Ortiz (1983) the term ‘dollarization’ refers to the widespread usage of US dollars for transaction purposes in Mexico. More recently, Ize and Levy-Yeyati (2003) use ‘financial dollarization’ for episodes in which do- mestic financial contracts are denominated in dollars or another foreign currency. In some countries, dollarization has been the outcome of official govern- ment policy. Examples include Ecuador in 2000 and El Salvador in 2001, where the domestic currency was retired from circulation and the US dollar became the official currency. An immediate implication of such ‘official dol- larization’ is that domestic prices of tradable goods are tied to world prices, so domestic inflation is closely related to US inflation. Hence official dol- larization has been advocated for countries suffering from chronic, high, and volatile inflation. On the other side of the ledger, official dollarization implies the surrender of independent monetary policy, leaving only fiscal policy available as a stabilization tool. In addition, the domestic government gives up seigniorage, or the revenue from money creation, which accrues to the US Federal Re- serve. While both effects are widely regarded as costly for the domestic economy, their welfare implications depend on details about the policymak- ing process and, in particular, on whether the monetary authorities can credibly commit to implement optimal policy (see Chang and Velasco, 2002, for a discussion). Finally, official dollarization implies that the domestic central bank is no longer available as a lender of last resort, which may be conducive to fi- nancial fragility and crises. Calvo (2005) argues, however, that last resort lending can be provided by alternative arrangements. Impetus for official dollarization as a policy alternative was greatest at the turn of the millennium, as emerging economies had to cope with a sequence of financial and exchange rate crises while several European countries were abandoning their national currencies in favour of the newly created euro. Support for official dollarization appears to have subsided since, however. More frequently, dollarization has emerged as a spontaneous response of domestic agents to inflation. The special case in which such a process has resulted in the dollar becoming a widespread medium of exchange is known as ‘currency substitution’. Currency substitution has been the subject of a large literature, much of it focused on the determinants of the relative de- mand for domestic vis-a` -vis foreign currencies and on implications for mon- etary management. Early research followed Girton and Roper (1981) in postulating ad hoc aggregate demand functions for domestic and foreign currency, in the portfolio balance tradition. Somewhat later, Calvo (1985) derived similar demand functions from an optimizing model in which do- mestic and foreign currencies entered the representative household’s utility 2 dollarization function. Those approaches emphasized the possibility that increasing sub- stitutability between the domestic and the foreign currencies would lead to monetary and exchange rate instability. However, they did not identify the basic determinants of substitutability, which was buried in the specification of the postulated demand function for foreign currency or the properties of the representative agent’s utility function. Hence the early studies were of little use in understanding how to cure the ills associated with dollarization, and, in particular, they failed to trace the consequences of common policies designed to deal directly with currency substitution, such as outright pro- hibitions on the holdings of foreign currency. Subsequent studies have attempted to address these shortcomings by modelling more explicitly the fundamental frictions underlying currency substitution. Thus Guidotti and Rodriguez (1992) developed a cash-in-ad- vance model of currency substitution on the assumption that using foreign currency entailed fixed transaction costs, while Chang (1994) studied the implications of a similar assumption in an overlapping generations setting. These models still left unexplained where the assumed transaction costs were coming from. Therefore, recent work on this area models currency substi- tution entirely from first principles, in the search theoretic tradition (see, for instance, Craig and Waller, 2004). Another focus of recent literature has been the increased use of the dollar as the currency of denomination of the debts of domestic residents in emerg- ing economies, a problem that Calvo (2005) terms ‘liability dollarization’. A substantial degree of liability dollarization places an economy in a vulnerable situation, since presumably many of the agents with dollar debts have assets denominated in domestic currency. Such a currency mismatch situation means that a depreciation of the domestic currency reduces the net worth of domestic agents. If, in turn, aggregate demand depends on net worth (as would be the case in the presence of financial imperfections), a currency depreciation may lead to a reduction in income and employment. In other words, liability dollarization may render depreciations contractionary, not expansionary as assumed by conventional analysis (Aghion, Bachetta and Banerjee, 2001; Cespedes, Chang and Velasco, 2004). The combination of liability dollarization and net worth effects has been blamed for the severity of the income and output contractions in recent emerging markets crises. At this point, no consensus exists as to the causes of liability and financial dollarization, although research on this question is rather active. Ize and Levy-Yeyati (2003), in particular, have examined the choice of currency de- nomination of assets and liabilities from a capital asset pricing model (CAPM) perspective, while Jeanne (2005) models liability dollarization as the private sector response to the lack of credibility in monetary policy. Finally, several studies estimate how measures of financial dollarization depend em- pirically on other characteristics of an economy. For example, Arteta (2005) has found that the dollarization of bank deposits is empirically more fre- quent in countries with a higher degree of exchange rate flexibility. Roberto Chang See also <xref=C000567> currency unions; <xref=xyyyyyy> money. dollarization 3 Bibliography Aghion, P., Bachetta, P. and Banerjee, A. 2001. Currency crises and monetary policy in an economy with credit constraints. European Economic Review 45, 1121–50. Arteta, C. 2005. Exchange rate regimes and financial dollarization: does flexibility reduce currency mismatches in bank intermediation. Topics in Macroeconomics 5(1). Calvo, G.A. 1985. Currency substitution and the real exchange rate: the utility max- imization approach. Journal of International Money and Finance 4, 175–88. Calvo, G.A. 2005. Capital markets and the exchange rate with special reference to the dollarization debate in Latin America. In Emerging Capital Markets in Turmoil, ed. G. Calvo. Cambridge, MA: MIT Press. Cespedes, L., Chang, R. and Velasco, A. 2004. Balance sheets and exchange rate policy. American Economic Review 94, 1183–93. Chang, R. 1994. Endogenous currency substitution, inflationary finance, and welfare. Journal of Money, Credit, and Banking 26, 903–16. Chang, R. and Velasco, A. 2002. Dollarization: analytical issues. In Dollarization, eds. E. Levy-Yeyati and F. Sturzenegger. Cambridge, MA: MIT Press. Craig, B. and Waller, C. 2004. Dollarization and currency exchange. Journal of Monetary Economics 51, 671–89. Girton, L. and Roper, D. 1981. Theory and implications of currency substitution. Journal of Money, Credit, and Banking 13, 12–30. Guidotti, P.E. and Rodriguez, C.A. 1992. Dollarization in Latin America: Gresham’s law in reverse? IMF Staff Papers 39, 518–44. Ize, A. and Levy-Yeyati, E. 2003. Financial dollarization. Journal of International Economics 59, 323–47. Jeanne, O. 2005. Why do emerging economies borrow in foreign currency? In Other People’s Money, eds. B. Eichengreen and R. Hausmann. Chicago: University of Chicago Press. Ortiz, G. 1983. Currency substitution in Mexico: the dollarization problem. Journal of Money, Credit and Banking 15, 174–85. Index terms aggregate demand capital asset pricing model currency substitution dollarization euro financial dollarization inflation lender of last resort liability dollarization monetary policy net worth effects portfolio balance search theory seigniorage stabilization transaction costs 4 dollarization Index terms not found: search theory.
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